When Economics Was Young

Virtually every economist in the world has heard of John Maynard Keynes. Many have heard of Friedrich Hayek. But few economists (and far fewer non-economists) know that the major controversy in macroeconomics in the 1930s was between Keynes and Hayek. Most economists under age 60 know little about the history of economic thought because, for the last three decades, Ph.D. economics programs have put little or no emphasis on it.

Thus, Keynes Hayek helps fill a big gap. Before reading Nicholas Wapshott’s book, I had known about the debate between Hayek and Keynes but hadn’t known many of the fascinating details, especially about the personalities involved. Now I do. Wapshott, a journalist who was senior editor at the Times of London, weaves an exciting tale in which not only the economic arguments, but also the players’ personalities, come alive. We see how the various young economists at the time — Joan Robinson and John Kenneth Galbraith, for instance — and middle-aged economists such as Arthur Pigou and Lionel Robbins — lined up. We also see a fair amount of cruelty towards Hayek among Keynes’s young acolytes. To be fair to Keynes himself, though, the book highlights his generosity of spirit toward Hayek — a spirit Hayek appreciated and reciprocated. The book’s subtitle is misleading (more on that later), but Wapshott rightly sees the Keynes/Hayek debate as an important subject.

Wapshott points out that before Keynes’s work in the 1930s, culminating in his classic The General Theory of Employment, Interest, and Money in 1936, there was no such field as macroeconomics. That is not to say that economists didn’t think about things like unemployment, inflation, and economic growth. They did. But they thought about those issues with the standard tools of economics that Keynes’s mentor, Alfred Marshall, and most other economists used.

Keynes changed all that by introducing the concept of “aggregate demand,” the demand for goods and services in general. Aggregate demand is made up of the demand for consumption goods, the demand for investment, government’s demand for goods and services, and exports minus imports. Keynes argued that there was nothing in market processes to ensure that aggregate demand would be high enough to lead to full employment. He was particularly concerned about investment demand because, he argued, the “animal spirits” of businessmen were not stable. If businesses became pessimistic, he thought, then investment demand would decline, causing aggregate demand to decline and unemployment to increase. That’s where Keynes saw a role for government policy to increase aggregate demand: either to cut taxes so that people, feeling wealthier, would consume more, or to, without increasing taxes, increase government spending on goods and services.

The neoclassical economists, whom Keynes in the General Theory incorrectly, but cleverly, labeled as classical economists, had always admitted that economies could go through recessions or even depressions. They argued, though, that relatively free economies would work their way out of depressions as long as prices and wages were flexible. If the demand for goods and services declined, according to the neoclassicals, wages and prices would fall, thus increasing the amount of goods and services and the amount of labor demanded.

But, Wapshott writes, Keynes thought that wages were “sticky.” That’s my interpretation of Keynes also, although there’s a whole cottage industry directed to figuring out what Keynes really believed about wages. With wages not falling, high unemployment could last a long time.

The fact that British unemployment in the late 1920s and early 1930s stayed stubbornly high gave a boost to Keynes’s way of thinking. Maybe wages weren’t so flexible as many neoclassical economists had believed. But Wapshott notes that one factor making wages “sticky” was high unemployment benefits, which made workers more resistant to wage cuts. He even quotes Keynes making that concession in a radio broadcast circa 1930. Wapshott could have bolstered his case with evidence that U.S. economists Daniel Benjamin and Levis Kochin presented in a path-breaking 1979 article about the connection between British unemployment benefits and Britain’s unemployment rate. In their article, published in the prestigious Journal of Political Economy, Benjamin and Kochin wrote:

By 1931 weekly benefits exceeded 50 percent of average weekly wages, and an adult worker who had made 30 weekly contributions at any time in his working career could draw full benefits for an unlimited period.

It shouldn’t have been surprising, then, that unemployment stayed high.

Where does Friedrich Hayek fit in? Hayek grew up in Austria and studied under the famous Austrian economist Friedrich von Wieser. In 1921, Hayek took a government job under Austrian economist Ludwig von Mises. In that job, Hayek experienced the Austrian hyperinflation that occurred at the same time as the horrible German hyperinflation. Wapshott notes that in just eight months on the job, Hayek received 200 pay raises. This experience made Hayek fearful of inflation until his dying day. Wapshott writes, “The Austro-Hungarian Bank printed notes night and day to keep up with demand.” That view of causation is a major misconception, although officials in the German and, presumably, Austro-Hungarian central banks at the time did hold it. The demand for money did not drive the printing of notes. Rather the printing of notes fed inflation, which, it is true, led people to want more notes. Without the original printing of money, the inflation would not have occurred and there would have been no issue of “keeping up.”

In 1928, Hayek was invited to a joint meeting of economists at Cambridge University and the London School of Economics. There, he quickly got into an argument with Keynes and, in doing so, impressed Lionel Robbins, one of the leading economists at lse. Robbins, uncomfortable with the interventionist direction in which he could see Keynes heading, had been looking around for someone to refute Keynes. Robbins saw a lot of promise in Hayek. So in 1931, he invited Hayek to give four lectures on the business cycle at lse. Hayek did so, but not before first giving a lecture at Keynes’s Cambridge, a talk that Keynes and his young entourage did not receive warmly. Hayek was a hit, though, with lse’s economics faculty, which responded by voting unanimously to offer him the Tooke Chair in Economic Science and Statistics. Hayek accepted.

As soon as Hayek joined the lse faculty, Robbins, also editor of the prestigious journal Economica, asked Hayek to review Keynes’s latest book, A Treatise on Money. In it, Keynes advanced some of the themes he would later develop in the 1936General Theory. Hayek wrote his lengthy review in two parts. Wapshott quotes at length from the first part. Hayek stated that Keynes’s book was “so highly technical and complicated that it must forever remain entirely unintelligible to those who are not experts.” “One can never be sure,” wrote Hayek, “whether one has understood Mr. Keynes right.”

Keynes was furious and, well before Hayek published part two, responded in Economica. Keynes wrote, “Any denial of his [Hayek’s] own doctrine has seemed to him so unthinkable that even thousands of words of mine directed to its refutation have been water off a duck’s back.” A back and forth debate by mail ensued. In those days, mail moved faster than now. Hayek even wrote Keynes on Christmas morning in 1931 and that afternoon (the Royal Mail, explains Wapshott, delivered twice daily, even on Christmas) Keynes replied.

In February 1932, Economica ran the second installment of Hayek’s review. Hayek kept up the insults and Wapshott quotes them, but Wapshott also quotes Hayek’s substantive argument. Hayek argued that government-funded public works would cause “inflation, forced saving, misdirection of production and, finally, a crisis.” Rather than replying, though, Keynes encouraged the young Italian economist Piero Sraffa to attack Hayek. Sraffa did. Keynes had Sraffa respond in kind by reviewing Hayek’s Prices and Production in the Economic Journal of March 1932. Sraffa found the book unintelligible. Interestingly, even some economists who leaned in Hayek’s direction did not find the book understandable. John Hicks, for example, an lse lecturer sympathetic to the Austrian School (later to become a Keynesian and much later to win the Nobel prize), stated, “Prices and Production was in English, but it was not English economics. It needed further translation before it could be properly assessed.” And Frank Knight of the University of Chicago stated his wish that Hayek “or someone would try to tell me in a plain grammatical sentence what the controversy between Sraffa and Hayek is all about.” Even today, economists still debate the issues that Sraffa and Hayek debated almost 80 years ago.

Meanwhile, Keynes turned his attention to completing the General Theory. Interestingly, even though Hayek, Keynes, and Sraffa had all leveled the charge of unintelligibility — Hayek on Keynes and Keynes and Sraffa on Hayek — with the publication of the General Theory, obscurity became a virtue. Wapshott quotes Paul Samuelson, who, in his famous textbook, Economics, popularized Keynesian economics for millions of American economics students. Here’s what Samuelson wrote on the General Theory:

It is a badly written book, poorly organized . . . It abounds with mares’ nests and confusions . . . An awkward definition suddenly gives way to an unforgettable cadenza. When finally mastered, its analysis is found to be obvious and at the same time news. In short, it is a work of genius.

Much later, Keynesian economist John Kenneth Galbraith wrote, “Unlike nearly all of Keynes’s other writing, this volume is deeply obscure.”

Wapshott writes that Keynes “went out of his way to invite Hayek’s criticism,” even sending Hayek advance copies so that Hayek could publish his critique by the time the book was released. Why? Writes Wapshott: “Keynes was a master publicist and knew the value of courting controversy.”

And how did Hayek respond? He didn’t. As Wapshott puts it, “Hayek declined to enter the ring.” Much later, Hayek would say that this was a “failure for which I have reproached myself ever since.” Part of Hayek’s reason, though, was that he was trying to finish a competing book, The Pure Theory of Capital, and had become “hopelessly stuck in chapter 6.” Hayek was still trying to work out, as young Austrian economists still do today, the effects of monetary policy, via interest rates, on the structure of production. Possibly because Hayek didn’t directly respond to the General Theory, some of the younger Hayek acolytes, such as John Hicks, Abba Lerner, and Nicholas Kaldor, went over to the Keynesian side. Wapshott quotes Galbraith’s observation about the various young Keynesian economists, especially Kaldor, attending lse seminars to poke cruel fun at Hayek.

Fortunately, Hayek didn’t quit. He wrote The Road to Serfdom, a volume that made him famous in the United States and one that Keynes called “a grand book.” Hayek seemed to have regrets about the work, though, because of some of the nastiness that American intellectuals heaped on him in response to it. In the 1980s, Hayek wrote, “I discredited myself by publishing” the book. (I think he used the word “discredited” differently from the way I would. The Road to Serfdom, though somewhat overstated, is a fine work. In context, Hayek seems to have meant that the book cost him some of his reputation.)

Hayek then turned to some of his path-breaking works on economics and knowledge. One of these was his 1945 article, “The Use of Knowledge in Society,” published in one of the most prestigious American economics journals at the time, the American Economic Review. This is probably one of the ten most important economics articles of the 20th century. With this and some earlier articles on the economics of knowledge, Hayek drove the final intellectual nail through the coffin of socialism.

Nevertheless, from the late 1930s on, Hayek felt as if he was in the wilderness. He became increasingly depressed, but his depression ended after he won the Nobel Prize in 1974. I saw him the next year at a weeklong conference and offered to carry his bag up some stairs so that I could get a chance to talk to him. There was a definite bounce in his step and a twinkle in his eye.

But is wapshott’s subtitle justified? Certainly, the clash between Hayek and Keynes was important. One might even argue that it should have defined modern economics. But did it? No. Keynesianism did lose ground from the mid-1960s on, but that was due mainly to Milton Friedman, not Friedrich Hayek. From the late 1950s to the late 1960s, Friedman delivered three body blows to the Keynesian corpus. The first was his 1957 book, A Theory of the Consumption Function, in which Friedman showed that consumption is not a function of current income, as Keynes had posited, but, rather, a function of what Friedman called “permanent income.” This meant that a government that tried to increase consumption with spending or with a temporary tax cut would not succeed because people would rightly regard both as temporary. The Bush II tax rebates of 2008 are a textbook illustration of the impotence of temporary tax cuts: They caused not even a blip in consumption spending.

Friedman’s second big hit on the Keynesian model was his now-classic book, co-authored with Anna J. Schwartz, A Monetary History of the United States,1867–1960. In it, they showed that every major recession in the United States was preceded by a fall in the money supply or in the growth rate of the money supply. And the biggest drop in the money supply in the almost 100 years they studied occurred in the first four years of the Great Depression. That finding undercut one of the main tenets of Keynesian economics: the idea that monetary policy has little effect and that fiscal policy (the use of taxation and government spending to shift aggregate demand and thereby affect the unemployment rate) is more potent.

Third and finally, in his 1967 presidential address to the American Economic Association, Friedman laid out how one could have a stagnating economy and inflation at the same time. This, he pointed out, was inconsistent with the dominant Keynesianism of the time. Lo and behold, in the early 1970s, the United States got “stagflation”: a recession combined with high inflation. Incidentally, Jimmy Carter, running for president in 1976, crystallized the concept with his “misery index” — the sum of the unemployment rate and the inflation rate — which he used effectively against his opponent, President Gerald Ford. Friedman himself said that the stagflation of the early 1970s was more important than any of his theoretical arguments in getting across the problems with the Keynesian model.

Wapshott mentions some of this, although he gets one key fact wrong. Friedman, he writes (Wapshott gives no credit to his co-author Schwartz except in a footnote), “studied every peak and trough in America from the mid-nineteenth century on and discovered that each downturn was preceded by an explosion in the supply of money.” In fact, Friedman and Schwartz found not an explosion in the money supply but the opposite: a reduction in the money supply or in its rate of growth. More important, Wapshott doesn’t inform the reader that Friedman’s accomplishments had little to do with Hayek.

To say, as I do, that the debate between Keynes and Hayek did not define modern economics is not to say that it couldn’t do so in the future. Many economists still have not fully contended with Hayek’s point that the information that matters most is held in decentralized form in the minds of each of us. But we aren’t there yet.

I shouldn’t leave this review without noting one major mistake Wapshott makes in discussing the recent financial crisis. Wapshott writes, “The mayhem suggested that the decades-long experiment in allowing barely restrained markets to generate growth and prosperity had failed.” In fact, markets, in Britain and in the United States, have been heavily restrained for almost a century. It’s true that free-market economists until recently were winning the intellectual battle. But they haven’t come close to winning the policy battle. Indeed, many of us think that if we had, the financial crisis would have been much less severe.

David R. Henderson is a research fellow with the Hoover Institution and an associate professor of economics at the Graduate School of Business and Public Policy at the Naval Postgraduate School. He blogs at www.econlog.econlib.org.

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